Friday, May 15, 2015

Are U.S. Pension Funds Delusional?

John Coumarianos of Institutional Imperative wrote a comment for MarketWatch, You could be on the hook for pension funds’ lofty stock-market views:
What do Connecticut teachers and Dallas policemen and firemen have in common? They’re public sector employees whose respective pension funds are projecting 8.5% annualized long-term investment returns.

Along with the Houston Firefighters Fund and the Milwaukee City Employees Retirement System, which also project 8.5% returns, the Connecticut Teachers Pension Fund and the Dallas Policemen and Firemen Fund have the highest assumed rate of return of any public employee pension fund in the Boston College Center for Retirement Research’s database.

Relative to their peers, none of these four pension funds have outlandish assumptions. All 150 public employee pension funds in CRR’s database have an average estimated investment return of 7.7%. Twenty funds are at the median (half the funds are higher and half are lower) assumption of 7.8% returns. Forty funds share the mode (most occurring assumption) of 7.5%.

Nearly 97% of the funds posts return assumptions in the 7%-8% range after rounding. This is an extremely tight data set with regard to return assumptions, which should make anyone wonder why there are almost no differences of opinion.

The lowest assumed rate of investment return (and the only one that clocks in under 6%) is the Pennsylvania Municipal Retirement System’s at 5.5% (click on image).


Unfortunately, relative to some respected investors’ estimates of what mainstream stocks and bonds are likely to deliver over the next seven-to-10 years, every fund in CRR’s database except the Pennsylvania Municipal Retirement System may be projecting unrealistically high returns.

Likely future stock and bond returns

The easiest way to question these 7%-8% pension fund investment return assumptions is to begin with bonds. The 10-year Treasury is currently yielding a bit over 2%. That means an investor holding the instrument to maturity will get the yield it delivers, nothing more and nothing less. Perhaps investment grade corporate bond holders will receive 3%.

While junk bonds are yielding in the 5%-6% range, that’s not much given the asset class’s historical average default rate. Because defaults have pronounced cycles — moments where they seldom occur and moments when they’re rampant — it’s likely investors have fooled themselves that the current low-default environment is permanent.

Many investors think emerging markets bonds will deliver a bit more — say, 2.5% after inflation, or 5% assuming a 2.5% rate of inflation.

So altogether, let’s say the bond part of a pension fund’s portfolio will return 3.5% for the next seven-to-10 years (not counting management fees).

If our bond return assumption is correct, the stock part of a balanced portfolio split roughly evenly between stocks and bonds will have to deliver more than 10% annualized for the entire portfolio to approach a 7% return. Stocks will have to deliver close to 13.5% to the Connecticut teachers or the Dallas policemen and firemen to sustain those public employees through retirement.

Can stocks rise to these feats of heroism over the next decade or so? Not likely, according to Boston-based asset manager Grantham, Mayo, van Oterloo (GMO).

GMO, which lists its asset-class return assumptions monthly, currently thinks most developed market stocks will produce negative real — or after-inflation — returns over the next seven years. The firm evaluates stocks on long-term metrics such as (but not exclusively) current price over past 10-years’ inflation-adjusted average earnings, also known as the “Shiller P/E” after Yale economics professor Robert Shiller. Based on past earnings, GMO says, stocks are expensive and therefore poised for low future returns (click on image).

Since GMO publishes real or inflation-adjusted return numbers, one can just add an inflation assumption (say, 2%-3%) to the return forecast to get a nominal number, which is what the pension funds use. For example, GMO’s expected negative 2.0% real return for U.S. large company stocks might be a 1% nominal return if you assume 3% inflation. That’s breathtakingly far away from what the pension funds are assuming.

In developed markets only the highest-quality domestic stocks — those that consistently produce returns on invested capital in excess of their cost of capital and may be said to have economic “moats” or durable competitive advantages — are priced to deliver a minuscule 0.5% annualized real return, according to GMO.

Emerging markets stocks are the best of the bunch at 2.7% annualized for the next seven years. If one assumes 2.5% inflation, that’s a 5.2% nominal return — still far from (likely only about half) what they need to deliver to satisfy pension funds’ total portfolio return assumptions.

Although the starting yield does well in predicting future bond returns, predicting future stock future returns is fraught with difficulty.

Nevertheless, the pension funds have already made assumptions about future returns, as they must, and it’s not clear they’ve put much thought into the exercise. While century-long returns of a balanced portfolio may be in the 7% range, such portfolios go through multi-decade periods without returning anything close to the century-long results.

The pension funds have evidently made no attempt to take a measure of current valuation to arrive at their assumptions. They seem to have lazily plugged in century-long returns to satisfy their assumption requirements.

As for the Shiller P/E and GMO’s work, they are based on past earnings rather than being a complete guess as to what might materialize in the future. GMO has good, if imperfect, records in forecasting future seven-to-10 year stock returns, as this academic paper indicates.

Revising return assumptions downward would undoubtedly cause pension funds pain. Failing to do so, however, will cause future pensioners and possibly taxpayers pain. Public sector pension funds need to go back to the drawing board — or need to be made to go back to the drawing board — to think about future returns.
This is another excellent comment discussing the pension rate-of-return fantasy. Unfortunately, NASRA is still smoking hopium and nobody wants to talk about the elephant in the room. I fear the worst for pensions as global deflation sets in, decimating them and forcing them to come to grips with the fact that 8% will turn out to be more like 0% or lower in coming decade(s).

Nonetheless, the talking heads on Wall Street are talking up global reflation and U.S. public pension funds are increasingly shifting assets into high fee private equity, real estate and hedge funds to make that 8% bogey. Unfortunately for them, they will fall well short of their target, but they will succeed in enriching a bunch of overpaid hedge fund and alternatives managers that are preparing for war.

In my humble opinion, U.S. public pensions should heed the wise advice of the Oracle of Omaha as well as that of the king of hedge funds and steer clear of this space (because most don't have a clue of what they're doing).

They should also pay close attention to Ron Mock, the President and CEO of the Ontario Teachers' Pension Plan, who recently sounded the alarm on alternatives. It's worth noting that unlike U.S. public pension funds, the Oracle of Ontario uses one of the lowest discount rates in the world to discount their future liabilities and they monitor all risks very closely as they try to match assets with liabilities.

In fact, Neil Petroff, the soon to be retired CIO of Ontario Teachers once told me flat out: "If U.S. public pension funds used our discount rate, they'd be insolvent."

And the reality is that a lot of U.S. public pension funds are insolvent and their fate lies in the hands of judges and taxpayers. Steve Moore at Forbes reports, Judges For Higher Taxes, Not Pension Reform, In Illinois:
Last week the Illinois Supreme Court overturned a state law that would help fix the state’s notorious pension crisis. What a tragedy for the state’s taxpayers. The justices basically ruled that the pension arrangements are iron-clad, although these pensions are on a course to bankrupt the state and imperil public services that Illinois families depend on. The unions come first. This could have negative consequences for more than half the states that are trying to defuse government employee pension time bombs. ‎

By way of background: Illinois has one of the deepest public employee pension holes in the nation. The long term deficit is estimated at above $110 billion and the red ink rises every year. Even in California – where several cities have declared bankruptcy – the pension sink hole isn’t as deep on a per capita basis.

The watchdog group Open the Books reports that there are more than 5,000 teacher and other education officials who receive an annual pension of more than $100,000 a year. Worse yet, half of all government employees retire with benefits before age 60. That’s more than twice what a typical private worker gets for having worked 12 months, not nine months, a year.

The Illinois court invalidated a 2013 pension fix that was enacted by a Democratic legislature and a Democratic governor, Pat Quinn. That law cut off the front door to the pension swindle – switching new workers into defined contribution programs like 401k plans. The law also adjusted the automatic cost of living adjustments (now at 3 percent annually regardless of inflation). The reform also adjusted the retirement age for new employees after January 2011, highly important because at least half of the employees covered are retiring before age 60—including 70 percent of teachers. Even the features of the law dealing with new employees entering the bankrupt system were unbelievably tossed out by the court meaning that the costs must keep rising inexorably into virtual perpetuity.

The victims of these daunting pension costs are citizens who rely on state services. Pension checks are crowding out funding for everything else and last year rose 12 percent as most state spending is being cut or frozen.

Thanks to this ruling, there is no way out of the pension calamity absent a repeal of the pension clause in the Illinois Constitution.

The state can’t borrow – it already has the worst credit rating in the nation. It has to borrow less – not more. Last week’s court decision sent interest rates on Land of Lincoln debt to even higher levels – near junk bond status. Days later, Chicago bonds were marked down to junk status.

The state is already making deep cuts in other spending programs. To accommodate lavish government retiree pensions, the court has rules that everything else – from funding for schools, roads, bridges, prisons, and ‎police services – gets whacked. Current Governor Bruce Rauner is taking on the unenviable job of cutting at least $6 billion from state spending in order to balance the budget. The Court just made his job doubly excruciating.

The liberal justices made no secret of their preferred fix: raise taxes. ‎They wrote: “the General Assembly could have also sought additional tax revenue,” and they chastised lawmakers for allowing a highly unpopular temporary tax increase to expire “even as pension funding was being debated and litigated.” But that tax hike was never meant to pay for pensioners even though most of the money was used to plug the massive growth in annual retirement payments. ‎

Raising taxes is an economic suicide pact for Illinois citizens. Illinois is already losing businesses and jobs due to some of the highest tax burdens in America. Raising taxes, as the pols in Springfield found out in recent years, raises almost no money because it accelerates the exodus to Texas, Florida, and Arizona.

The Court rejected the plea by lawmakers and others that the pension crisis qualifies as an emergency that grants the legislature the option of disregarding the pension protection clause. But this problem is a financial ticking time bomb that imperils funding for basic services that taxpayers and businesses depend on. ‎Is it not an emergency if the municipalities can’t get ambulances or fire trucks to their residents for lack of funds?

As in so many states today, pension costs in Springfield are crowding out funding for basic municipal services taxpayers depend on. The cost of borrowing keeps rising because of investor fear that these states will soon look like Greece. Balancing the budget now seems impossible. And the only people feeling financially secure are the state’s retired government employees – many of whom have moved to Palm Beach and Phoenix.

If courts won’t allow states to trim pension costs, eventually states like Illinois will rush to Washington for federal bailout money. With more than $1 trillion in unfunded public pensions nat‎ionwide, Illinois is looking like the canary in the coal mine. What a tragedy if courts in other states prevent legislatures from defusing these fiscal time bombs.
It's funny how the media is focused on dwindling pensions in Greece when the reality is that Illinois, Kentucky and other states are the next Greece. I started writing about pension bombs exploding everywhere back in 2008. Nobody was taking me seriously back then but they're reading me now and scared to death of what's going to happen with their pension.

While the Forbes article above raises excellent points, I don't particularly like it because it ignorantly promotes 401(k)s as the ultimate pension fix. This is pure rubbish. The 401(k) experiment has been an abysmal failure in the United States of Pension Poverty and the brutal truth is that defined-contribution plans don't mitigate against pension poverty, they exacerbate it.

As I stated in my last comment on Social Security, the only real long-term solution to the retirement crisis gripping the United States is to follow the model of the Canada Pension Plan whose assets are managed by the CPPIB. Of course, to do this properly, U.S. policymakers need to get the governance right and have the assets managed at arms-length from any government. And the big problem with U.S. public pensions is they're incapable of getting the governance right.

Why am I such a stickler on enhancing the CPP for all Canadians and enhancing Social Security for all Americans? Very simple. I believe the world is heading down a very uncertain path and in this environment, I want to see people's pensions managed by professional pension fund managers who can lower costs and invest across public and private market assets and anything in between.

The added advantage of enhancing the CPP or Social Security is people can pretty much work across the public and private sector and their pensions would be safely managed by professional pension fund managers (no issue of pension portability). Companies which are already dropping defined-benefit pensions wouldn't need to worry about pensions, they would just contribute to their employees' pensions.

It's also worth mentioning once again that good pension policy is good economic policy. The benefits of defined-benefit plans are not well understood or appreciated but when people retire knowing they have fixed payments till they die, they're able to spend more and governments are able to collect more taxes. In the long-run, enhancing defined-benefit plans isn't going to increase debt. If done right by introducing risk sharing, it will lower debt and help mitigate against downturns in the economy.

As far as young teachers, police officers, firemen, and other public sector workers working in the U.S., I'll give you the same advice that I give my girlfriend who is a young teacher here in Quebec. Even if you have what seems as a safe pension, don't take it for granted and save whatever you can, investing in dividend ETFs because you simply don't know what the future holds.

I personally learned that lesson the hard way. First in June 1997 when I was diagnosed with multiple sclerosis (MS) and second in October 2006 when I was wrongfully dismissed at PSP after warning Gordon Fyfe and their senior managers of the credit crisis. I know all about life and death on Wall Street and what it means to struggle when the odds are against you.

But I also learned a much more important lesson in life, the value of perseverance, self-discipline and focusing on what really matters and the people that truly love me. Trust me, there are a lot funner things I can be doing with my time than spending a few hours a day writing a blog on pensions and investments but I take the issue of retirement security extremely seriously and have devoted a good chunk of my life on this topic trying to help promote a healthy and much needed discussion on reforming pensions for the better, not worse.

All I ask from my readers is that you take the time to click my ads and donate or subscribe to my blog on the top right-hand side. Institutions that can afford to give a lot more are kindly requested to subscribe using one of the three options. I thank all of you who have done so and ask others to follow suit.

Below, Manhattan Institute Senior Fellow Steve Malanga and Chicago radio talk show host Dan Proft on growing concerns over Illinois’ pension crisis. Illinois has yet to slay its pension dragon and is heading the way of Detroit and Greece. Unfortunately, so are many other state plans suffering from the delusions of lofty investment assumptions which simply won't materialize.

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